Undervalued Dividend Growth Stock of the Week: Wal-Mart Stores, Inc. (WMT)

When was the last time you went shopping for something and you picked up some merchandise that you just know you scored a deal on?

Feels good when that happens. Doesn’t it?

Of course it does.

We all want to keep more money in our pocket. No one wants to spend more money than they have to.

Well, that same thought process translates well when talking about buying stocks.

I love buying high-quality dividend growth stocks, but I love routinely paying less than intrinsic value even more.

See, every stock has a price.

Just like any other merchandise in the world, there’s a price to pay for a share in any publicly traded company.

And you can easily see these prices at any time by pulling up a stock quote.

But how do you know what these shares are actually worth?

How do you know if the price is in line?

How do you know if you’re getting a good or bad deal?

Well, how do you know if you’re getting a good deal on anything in life?

Stocks work just like everything else. You have to be able to value stocks in order to know whether or not you’re getting a good deal.

Price is what you pay for something. But value is what something is actually worth. Value is what you get in return for your money.

You might feel good when you score a deal at the mall or the grocery store, but why do you feel good? How do you know you scored a deal?

Obviously, you’re either consciously or subconsciously valuing the merchandise as you go. You inherently know (or you should inherently know) what something is worth before you pay for it.

The thing with stocks is that this isn’t natural. People don’t buy stocks all the time, so they’re not used to going about valuing them before they buy them. Moreover, it’s more difficult to value a business worth billions of dollars than it is a pair of jeans or a loaf of bread.

But fear not.

There are a lot of ways to go about valuing stocks. And it’s actually not all that hard once you get the hang of it.

One such way to go about it is a system that was discussed by Dave Van Knapp, an experienced author and investor on the subject.

Now, you don’t have to use that system.

But by checking it out, you’ll see there are concrete ways to use art and science to arrive at a reasonable estimate of what a business – even a really big business – is intrinsically worth, which then allows you to determine whether or not the price a stock is going for is a good deal or not.

And why wouldn’t you want a good deal on stocks? You feel good when you score a deal on groceries. Just imagine that same feeling multiplied by about 100 when buying a stock for less than it’s worth.

Scoring a good deal on normal merchandise is a one-time event. You save the money and that’s it.

But scoring a good deal on stocks is like the gift that keeps on giving.

Your potential total return is much higher, first of all.

In addition, your yield is immediately boosted since price and yield are inversely correlated, all else equal.

Most importantly, however, any dividend raises you receive that are based off of a higher yield have a larger overall impact on your income.

This makes sense. A 10% increase on a 5% yield is a lot more than a 10% increase on a 4% yield.

I’ve developed my own technique (which I’ll go over later), and I commonly use that technique when looking at high-quality dividend growth stocks.

These are stocks that not only pay dividends to shareholders because shareholders have a rightful claim to a portion of a company’s profit, but these stocks also regularly increase these dividends so that shareholders’ purchasing power is constantly growing.

Just like you expect a raise at work, I expect a raise as a shareholder.

Dividend growth stocks are almost solely the only stocks I invest in.

And they’re also the only stocks you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible compilation of the more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.

Recently, I used my technique on a high-profile and well-known dividend growth stock on Mr. Fish’s list, and also a stock I already own in my own portfolio.

After doing so, I realized the stock appears to be undervalued right now, perhaps significantly so. And so I saw that as an opportunity to increase the size of my position in the company.

I also see an opportunity to share that information with you readers, and so that’s exactly what I’m going to do.

Wal-Mart Stores, Inc. (WMT) is a global retailer that operates more than 11,000 stores across the world.

Long known as a low-price leader when it comes to merchandise, the stock now appears to be low priced.

Wal-Mart’s motto is: “Save Money. Live Better”. But I think we should save money and invest better.

First, let’s just take a look at the incredible dividend growth track record here.

The company has increased its dividend for the past 42 consecutive years.

That four-decade stretch includes massive change both in the retailing industry and the world at large. So if you’re looking for some assurance for increasing dividend income, this stock is about as good as any.

Now, recent dividend increases have been somewhat underwhelming. Change in retailing has never been as fast or intense as it is now, and the company has remained somewhat cautious. I actually view that as a positive aspect.

Nonetheless, the 10-year dividend growth rate (even factoring in recent small raises) is still 14.8%. Over the long haul, the dividend is definitely increasing at a rapid rate.

sc wmtMeanwhile, the stock yields a monster 3.10% right now.

That’s an all-time high.

For perspective, the five-year average yield for WMT is 2.3%. So you’re looking at an 80-basis point spread there, which is huge.

And with a payout ratio of just 41%, there’s still plenty of room for the company to continue growing its dividend at an aggressive rate, even if EPS growth trails slightly.

At first glance, some might think that Wal-Mart is dying off because of the increasing frequency of online purchases. Recent results have been somewhat underwhelming, but one has to keep in mind that it’s tough to move the needle meaningfully when you’re taking in almost $500 billion in revenue per year as the world’s largest retailer.

Moreover, e-commerce sales growth for the retail juggernaut has been robust.

But let’s take a look at the last ten fiscal years, which is a time frame that certainly includes plenty of online competition – online shopping wasn’t invented last year, after all.

The company’s revenue increased from $315.654 billion in fiscal year 2006 to $485.651 billion in FY 2015. That’s a compound annual growth rate of 4.90% over that period.

Top-line growth in the mid-single digits is actually pretty solid for a company with numbers this large.

Earnings per share is up from $2.68 to $5.05 over this period, which is a CAGR of 7.29%.

Excess growth across the bottom line was helped somewhat dramatically by the company’s ongoing share buybacks, which are substantial. The outstanding share count is down by about 23% over the last 10 years. And Wal-Mart continues to aggressively buy back stock.

Looking at future growth, I think expecting that ~7% growth in EPS is reasonable. S&P Capital IQ anticipates that the Wal-Mart will grow EPS at a compound annual rate of exactly that much – 7% – over the next three years, believing that share buybacks, improved efficiency, and gains from e-commerce and smaller-format stores will all help the bottom line.

Wal-Mart has long maintained a healthy balance sheet with a responsible amount of leverage, and that continues to this day. The long-term debt/equity ratio is 0.51 and the interest coverage ratio is just over 11, as of the last fiscal year. No issues here at all.

Profitability for the firm is strong. Wal-Mart has incredible economies of scale, and their massive footprint and volume gives them pricing power over suppliers. This pricing power shows up in the margins and return on equity. Retailing is fraught with low margins due to competition, low (or non-existent) switching costs, and an obsession with price, but Wal-Mart historically does very well here.

Over the last five years, the company averaged net margin of 3.49% and return on equity of 21.97%. These numbers, on the whole, are at or near the top of the industry. And recent results have shown no marked deterioration.

Overall, we have a high-quality dividend growth stock here.

More than four decades of dividend raises. A yield well in excess of its average and that of the broader market. Great profitability. Reasonable debt. An industry leader still at the top of its game with plenty of potential with smaller-format stores and e-commerce.

We might expect to pay a big premium for this stock. But is that the case?

The P/E ratio for WMT sits at 13.24 right now. Not only is that low in absolute terms, but it’s also quite a bit lower than the five-year average P/E ratio of 14.3 for this stock. Moreover, as mentioned, the current yield is substantially higher than the average over the last five years, meaning today’s investors are getting a much higher yield than what’s traditionally been available on this stock.

So not only is a premium absent, but a discount seems to be present. What’s the stock worth, though?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate is below the long-term growth for EPS and the dividend. Although recent raises have been low, the long-term average is attractive. And a low payout ratio means there’s a lot of wiggle room. The DDM analysis gives me a fair value of $69.91.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

I believe a clear discount is present on this stock right now, but I’m not the only one in the world looking at WMT. What do some professional analysts think about the valuation?

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates WMT as a 4-star stock, with a fair value estimate of $79.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates WMT as a 4-star “buy”, with a fair value calculation of $69.80.

Boy I was within pennies of what S&P Capital IQ thinks the stock is worth. But there’s a trend here. The stock appears undervalued across the board. If we were to take those three numbers and average them out so as to smooth the results out and come up with one number to work with, we get $72.90. That valuation would indicate the stock is potentially 15% undervalued right now.

wmtBottom line: Wal-Mart Stores, Inc. (WMT) is the world’s largest retailer with incredible economies of scale and pricing power. Fantastic profitability and more than four straight decades of dividend raises are results of that. There’s still a lot of potential here, and the dividend raises look set to continue for the foreseeable future. Moreover, the stock offers an all-time high yield and the possibility for 15% upside. I recently added to my position. You may want to consider the same.

— Jason Fieber, Dividend Mantra

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